FACULTY OF COMMERCE

DEPARTMENT OF ACCOUNTING AND FINANCE

CAC 313 – PRINCIPLES OF TAXATION
Bachelor of Commerce

BUSINESS INCOME

Introduction
Section 2 of the Income Tax Act (Cap. 470 Laws of Kenya) defines a “business” to

includes any trade, profession or vocation, and every manufacture, adventure and

concern in the nature of trade, but does not include employment.

A business will involve the buying and selling of goods and services but the mere

activity of selling of goods and services may not constitute a business. The following

are some of the common Indices of trade: -

a) Profit Seeking Motive: This is a prima facie evidence of a business activity. It is

more pronounced in companies and partnerships, which are formed mainly for

carrying out profitable operations as specified by their memorandum of

Association and partnership agreements. For an individual it is not easy to rule

out an isolated transaction is a trading venture without getting other facts

(indicators) associated with the transaction.

b) Mode of acquisition: This refers to the way the asset was acquired, it is therefore

easy to conclude that trading has taken place where an asset was purchased and

then sold thereafter as opposed to where it was inherited and then sold, making

the latter sale likely non-trading venture.

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c) Nature and Quantity of Asset: This can be a pointer to trading say where a person

purchases an asset (say a tractor) that is not used privately (say for enjoyment

purposes) or from an investment point and sells it later. Any gains arising are

likely to be trade profit given that such a transaction would be mainly motivated by

commercial speculation. In addition, dealing in large quantity of goods is a

pointer to a scheme with a profit motive.

d) Length of Time Asset is Held: The shorter the interval between purchase and
sale of an asset, the higher the likelihood that the acquisition was motivated by

profit in contrast, when an asset is acquired, held for a longer period and used (say

for residential purposes or to earn rent) it is easy to deduce trade granted the use it

was put in by the buyer before selling it.

e) Treatment of Asset while Held: This is an important pointer especially where it

is repaired, blended, reconstructed or renovated so as to enhance its value and

fetch a higher price when sold. These acts are motivated by profit motive.

f) Number of Transaction: Where they are numerous, serial or carried out

methodically; they are likely to be pointers of trading venture. However, courts

have also held that a single isolated transaction could constitute a trade or a piece

of business.

g) Business Interest in the same Field: Where one engages in related or connected

activities, the second line of activity is likely to be trading i.e. A Motor vehicle

dealer engaging in spare part sale of insurance brokerage for vehicles.

h) Method of Financing: A purchaser who buys goods and pays for them from sales

proceeds from a previous sale or borrows money to buy goods and then sells them, is

likely to be engaged in a trade.

i) Destination of Proceed: This may also be a trading indicator where such proceeds
are used to acquire a similar asset, unless the asset was held as an investment and

then sold and replaced by a similar investment.

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j) Sale organization: This is a pointer to trading where a person organizes his selling

system can determine whether trading is going on or not granted that the sale

may be promoted by advertising or engaging a sales person.

Having looked at the ten factors, one can tell whether trading is going on or not, which is

easy to detect in case of an ordinary business but not so for borderline cases.

However, it is important to note that these factors must be looked at in entirety and

not singularly, each case must also be dealt with on its own merit/facts.

Income Tax Computation of Business Income

For the purposes of section 3(2)(a)(i) of the Income Tax Act (Cap. 470 Laws of Kenya)

where a business is carried out or exercised partly within and partly outside Kenya

by a resident person, the whole of the gains or profits from such business will be

deemed to have accrued in or been derived from Kenya and is taxable. However, any

loss in the business is carried forward to be offset against the profit in the following

period up to 10 years. The accounting net profit/loss from a business must be adjusted

for income tax purposes.

Allowable and Non-Allowable Deductions

1. Allowable Deductions

Pursuant to section 15(1) of the Income Tax Act (Cap. 470 Laws of Kenya), for

ascertaining the total income of a person for a year of income there shall, be deducted

all expenditure incurred in that year of income which is “expenditure wholly and

exclusively incurred” by him in the production of that income.

Where under section 27 (Accounting Periods not coinciding with year of income) any

income of an accounting period ending on some day other than the last day of that

year of income is, for ascertaining total income for that year of income, taken as income

for that year of income, then the expenditure incurred during that period shall be

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treated as having been incurred during that year of income. Examples of Allowable

deductions may include: -

(a) Any cost an employee incurs in running or maintaining a car to enable him to

perform his duties

(b) Any costs an employee incurs on traveling for performing his duties

(c) Cost of living away from home necessitated by employment

(d) Cost of tools and implements if the employee provides his own

2. Disallowable Deductions

Section 16 (2) of the Income Tax Act (Cap. 470 Laws of Kenya), provides that,

notwithstanding any other provision of the Act, no deduction shall be allowed in

respect of the following: -

(a) Expenditure incurred by a person in the maintenance of himself, his family or

establishment or for any other personal or domestic purpose including the

following: -

(a) Entertainment expenses for personal purposes; or

(b) Hotel, restaurant or catering expenses other than for meals or

accommodation expenses incurred on business trips or during training

courses or work-related conventions or conferences, or meals provided to

employees on the employer’s premises;

(c) Vacation trip expenses except those customarily made on home leave as

provided in the proviso to section 5(4) (a)-Passages;

(d) Educational fees of employee’s dependents or relatives; or Club fees

including entrance and subscription fees except as provided in section

15(2(v)-paid by employer.
(b) Expenditure or loss which is recoverable under any insurance, contract, or

indemnity;

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 (c) Income tax or tax of a similar nature including compensating tax paid on income;

except foreign tax in respect of which a claim is made under section 41(Special

Arrangements for relief from double taxation.), a deduction shall be allowed in

respect of income tax or tax of a similar nature paid on income which is charged

to tax in a country outside Kenya to the extent to which that tax is payable in

respect of and is paid out of income deemed to have accrued in or to have been

derived from Kenya.

(d) Premium paid under an annuity contract;

(e) Expenditure incurred by a non-resident person not having a permanent

establishment within Kenya.

Adjustment Rules for Net Profit/Loss

a) Add back disallowable expenses if already deducted i.e. Personal salaries, personal

expenses, capital expenses, and Depreciation & general provisions for bad

debts etc.

b) Add any assessable income, which has been omitted.

c) Deduct the allowable expenses, if not already deducted i.e. expenses wholly and

exclusively incurred in the production of that income, this includes capital

deductions.

d) Deduct any in assessable income if already included.

Illustration
Anna-Marie posted the following figures for the year ended 31st December 2018.

Kshs. Kshs.

Sales 800,000

Cost of sales

Opening stock 100,000

Purchases 600,000

700,000

Less: Closing stock (150,000) (550,000)

Gross profits 5 250,000

Other Incomes

Dividends (BAT) 50, 000

Interest (KCB) 50, 000 100, 000

Total income 350, 000

Sundry expenses (200,000)

Net Profit 150,000

In the sundry expenses the following were included: Purchase of computer 60,000;

Personal salary 20,000; Stationary 10,000; Electricity 20,000

Required

Calculate his taxable income

Income from Management and Professional Fees

A profession is the exercise of and skill obtained through specialized training; such

profession may be exercised independently through self-employment. In case of such

self-employed professionals, returns of income will be made based on fees earned

during that accounting period. Expenses may be claimed against the incomes of the

same principal as for a normal trading concern. That is the expenses to be allowed

must have been incurred, wholly and exclusively in earning that income. In addition to

the normal expenses the following are also allowable: -

(a) Cost of replacing existing/obsolete books.

(b) A proportion of car expenses and W&T deductions may be allowed to the
extent that the car was used for professional services.

(c) A proportion of rent if dwelling house is used as office may be deducted.

(d) Professional subscriptions made by a self-employed professional are allowable.

(e) Payment by local branches to the head office are disallowed as business

expenses

The Income Tax Act (Cap. 470 Laws of Kenya), recognizes the following professions:

a) Medical: Any person who is registered as a medical practitioner under the

Medical Practitioners and Dentists Act

b) Dental: Any person who is registered as a dentist under the Medical Practitioners

and Dentists Act

c) Legal: Any person who is an advocate within the meaning of the Advocates Act
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d) Surveyors: Any person licensed as a surveyor under the Survey Act.

e) Architects & Quantity Surveyor: Any person who is registered as an architect or

 a Quantity surveyor under the Architects and Quantity Surveyors Act

f) Veterinary Surgeons & Veterinary: Any person who is registered or licensed as

a veterinary surgeon under the Surgeons Act

g) Engineers: Any person who is registered under the Engineers Registration Act

h) Accountants: Any person who is registered as an accountant under the

Accountants Act

i) Certified Public Secretaries: Any person who is registered under the Certified

Public Secretaries Act of Kenya (Sec 133)

6.4.1. Sole Proprietorship

A sole proprietorship is simply a business structure operated and owned by one

person. The person remains solely liable to all the losses and returns of the business.

Starting a business as a sole proprietor is cheaper and easier to set up compared to

limited company. This legal structure for a business gives more control to the

entrepreneur over decision making in all different parts of the business.

Taxation of Sole Proprietorship

Sole proprietorship businesses are not entirely required to file for taxes as a business

to Kenya Revenue Authority, rather they can do this through Income Tax Return as

an individual every June 30 th. If Sole proprietor charges VAT on his or her

products/services, then they are required by law to make monthly returns before 20th

of every month.

Advantages of Sole Proprietorships

1. Ease of formation: Becoming a sole proprietor is as simple as buying newspapers

and selling on the street, one only needs to develop an idea, set goals and then

develop it into a profitable operation. The simplicity of a sole proprietorship makes

this form of business structure attractive to small entrepreneurs.

2. Tax benefits: As an individual, owners of sole proprietorships file individual tax

returns and list down the figures and information in their individual returns. This

saves extra costs of accounting and tax filling. The business is therefore taxed at

the rate of personal income instead of 30%7as a corporation.

3. Decision-making: The owner has control of all decisions and makes them alone.

This makes it easy to make business decisions.

4. Secrecy: The owner alone handles the whole business and one person knows most
of the business secrets. The owner can maintain high standards of secrecy of profits or

special techniques.

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Disadvantages of Sole Proprietorships

1. Unlimited liability: The business owner will be held directly responsible for any

losses or debts coming from the business.

2. Lack of continuity: The continuity or permanence of a sole proprietorship is

difficult to maintain. If the owner dies or is incapacitated and there is no suitable

successor, the business will not continue.

3. Difficulty in raising funds: The volatile nature of sole proprietorship makes it

difficult for other investors to put their money into such a business. This is

especially when the business needs to grow.

6.4.2. Partnerships (excluding conversions)

A partnership is a relationship that subsists between two or more people carrying on

business together with a view to making profits. Gains or profits from a partnership

are assessed on the partners and not the partnership. The profits/losses arising from

the partnership is added to the partner’s total income from another source. A

partnership is usually established by an agreement known as a “partnership deed”

which outlines the following: -

(a) Amount of capital to be contributed by each partner

(b) Salaries to be paid to partners

(c) Interest to be charged on drawings by partners

(d) Interest to be paid on capital contributed by partners

(e) The profit-sharing ratio

In the absence of a deed it is assumed that, there is no interest paid on capital, no

interest charged on drawings, no salaries payable to partners and that, profits & losses

will be shared equally

Taxation of Partners

The income of the partnership is taxed on the 8partners.

The net profits/losses of a partnership must be adjusted for taxation of purposes, this
includes adding back disallowable expenses if already deducted and deducting

nontaxable incomes if already included. These adjustments are: -

(a) Expenses to be allowed must have been expended wholly and exclusively in

the production of that income.

(b) Capital expenses are not allowable

(c) Personal expenses are not allowable

(d) Salaries to partners are not allowed

(e) Interest on capital to partners is not allowable

(f) Interest paid by partners on drawings is not taxable

(g) Wife’s salaries are not allowable

(h) Drawings are not allowable

(i) Disposal of fixed assets is not taxable

After these adjustments, net amount is then distributed to the partners as per the deed

Illustration
Henry & Grace are in partnership and share profits/losses equally in the year of income

2018 when they posted a loss of Kshs.65, 000. Their accounts were as follows: -

Incomes Kshs

Dividends (KCB) 40,000

Interest (BIDCO) 50, 000

Sales 600,000

Disposal of delivery van 20,000

Refund of income tax 65,000

Sales of Grace’s Shamba 250,000

Expenses:

Purchases 300,000

Salaries: - Henry 40,000

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 - Grace 50,000

Interest on capital: - Henry 20,000

- Grace 20,000

Commission to Henry 40,000

Purchase of van 400,000

Advertising 100,000

Workers’ salaries 20,000

Electricity 100,000

Required

a) Adjusted partnership profit/loss

b) Distribution of the partnership profit/loss

6.4.3. Incorporated Entities (excluding specialized institutions)

Corporation tax is charged at 30% for residents and 37.5% for non-residents on

company incomes after the adjustment of the same in the same manner as discussed

under 1.4.

However, the following items should be allowable.

(a) Director’s fees paid out wholly and exclusively to produce the income.
(b) Director’s salaries are allowable

(c) Payments made between two associated companies are allowable.

Deductions not allowable are:

(a) Bad debts related to loans advanced to Directors

(b) Formation expenses

(c) Dividends and other distribution from profits

(d) Corporation tax

(e) Interest/penalties on arrears on corporation tax

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Illustration

Lake Nakuru Ltd. posted the following accounts in the year 31st December 2018.

Incomes Kshs. Kshs

Gross profits 2,000,000

Deposit interest 50,000

Dividends 400,000

Discounts received 50,000

Total income 2,500,000

Expenses

Salaries and wages 120,000

Rent & rates 130,000

VAT 100,000

Electricity 10,000

Insurance 30,000

Office expenses 50,000

Dividends paid 200,000

Neon sign post 180,000

Directors holiday payment 100,000

Corporation tax 120, 000 1, 040,000

Net Profits 1, 460,000

Required

i) Compute adjusted Net Profit

6.4.4. Turnover Tax (TOT)

Turnover tax was introduced vide Finance Act of 2006 through the provision of the

Income Tax Act (Cap. 470 Laws of Kenya), under Section 12C and become operational

on 1st January 2008 until it was replaced by Presumptive tax by the Finance Act, 2018.

The applicable rate is 3% of the gross income from business, no expenditure or capital

allowances is granted. TOT is a final Tax

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Interpretation
A. “Income from Business” - Includes gross receipt, gross earnings, revenue,

takings, yield, proceeds or other income chargeable to tax under section 12c.

B. “Person” - includes partnerships, individuals

C. “Tax period” - Means every three calendar months commencing 1 st January

every year

Eligibility, Registration & Administration of TOT

Persons whose income from business exceeds Kshs 500,000 but not more than Kshs

5,000,000 in any year of income is be liable to pay turnover tax, unless such a person

elects not to be subject to turnover tax by notice in writing to the commissioner. In

which case the person shall be liable to pay corporate tax, however turnover tax shall

not apply to: -

- s income and management or professional or training fees

- Income of incorporated companies

- Any income which is subject to a final Withholding tax i.e. Interest & Dividends

received by individuals

A registered person is issued with a certificate (TOT2) and shall be required to keep

records including: -

a) Cashbooks

b) Sales receipts and invoices

c) Daily sales summary (TOT 4)

d) Purchase invoices

e) Bank statements
Where a business is in possession of an Electronic Tax Register (ETR) records as

provided under the VAT Act (ETR) Regulations, 2004, those records shall be sufficient.

Turnover Tax is due on or before the 20th day of the month following the end of the

quarter/tax period. However, one may remit tax due on monthly basis and offset the

tax paid in the tax return. Failure to submit a return or submits the return and fails to

pay the tax due is liable to pay a default penalty of two thousand shillings.
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Benefits of Turnover Tax

(i) Easier tax procedure and simplifies tax computation

(ii) Makes return filling easier and simplifies record keeping

(iii) Reduces cost of compliance

Update: Imposition of presumptive income tax

Eligibility: Presumptive tax is only be applicable to persons whose turnover from

business does not exceed KES 5,000,000 per annum, who are issued a single business

permit by the County Governments and is not applicable to the following:

1) management and professional services; or

2) rental business; or

3) incorporated companies

Rate: The rate of the presumptive tax is 15% of the single business permit fee, is final

tax and is payable at the time of payment of the single business permit or renewal of

the same.

Deregistration: A person may opt out of the presumptive tax upon notifying the

Commissioner, after which the person will be liable to tax on his/her income in the

normal way.

Analysis: The success of this measure will depend on its implementation and will

require collaboration with the county governments.

While the introduction of presumptive tax appears to collect less tax as compared to

turnover tax, the ease of its implementation and administration will enhance its reach

and expand the tax base. It may also be used to enroll new taxpayers for ease of

follow-up should the government decide to increase the tax rate in future.

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 6.6. Farming Income

Profits arising from farming activities are subject to tax just as trade and professions

except hobby farming. Expenses incurred in earning such profits are also allowable

Hobby Farming: If farming is carried on without a view to the realization of profits it

may be exempted from taxation this will arise if the owner of the firm consumes a bigger

proportion of the farm produce. Income from such ventures is not taxable.

Treatment of Capital Expenditure

(a) Any expenditure of capital nature that is incurred in prevention of soil erosion is

allowable.

(b) Capital expenditure incurred in clearing of land or clearing and planting

permanent or semi-permanent crops are also allowable.

(c) A farmer is also entitled to farm work deductions.

Illustration

Bob Marshall is a farmer, he decides to sell off his cows and purchase pigs. His income

for the year 2018 was as follows: -

Incomes: Kshs Kshs.

Disposal of cows 156,000

Income from camping site 62,000

Sale of farm produces 200,000

Expenses:

Purchase of pigs 100,000

Clearing bush to plant 10,000

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Planting potatoes 20,000

Construction of pig sty 30,000

Interest paid on bank loan 20,000

Works to stop soil erosion 20,000

Purchase of fertilizer 30,000

Donation to local church 20,000

Subscription to Kogelo sports club 10,000

Court fine 30,000

Required:

Calculate his taxable income

Solution

Bob Marshall

Taxable income for the year ended 31st December 2018

Item Kshs Kshs

Disposal of cows (156,000 - 100,000) 56,000

Income from camping site 62,000

Sale of farm produces 200,000

Total Income 318,000

Less:

Clearing bush to plant 10,000

Planting potatoes 20,000

Interest paid on bank loan 20,000

Works to stop soil erosion 20,000

Purchase of fertilizer 30,000 (100,000)

Taxable Farming Income 218,000

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 6.7. Investment Income

A. Dividend Income
Dividend refers to the distribution of profits of a company to its shareholders.

Dividend is considered in the year in which it is paid to the shareholders

a) Qualifying Dividends
These are dividends, which are taxed at the point they are paid to the shareholders.

This tax is called withholding tax, and dividends subject to this WHT are not taxed

again. All dividends received by a resident will be qualifying dividends

b) Dividends not paid in Cash

(a) When a company issues debentures or redeemable preference shears to any of

its shareholders and receives no payment from the shear holder, the issue of

such debentures or redeemable preference shares shall be deemed to be

payment of dividends. The value of such dividends shall be the nominal value

or redeemable value whichever is higher.

(b) Where a company issues debentures or redeemable preference shares to its

shareholders at a sum or amount less than the nominal value the issue of the

debentures or redeemable preference shares shall be deemed to include a

payment of dividend equal to the difference provided that if the sum paid for

such debentures or preference shares is 95% or more of the nominal value then

there is no dividend.

Item A (Kshs) B (Kshs) C (Kshs)

Nominal 100 100 120

Value

Amount Paid 95 75 75

Value of NIL 25 45

Dividend

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Illustration

In the year 2018 Mr. Joshua Ekale who is a resident earned the following incomes: -

o Salary 30,000 p.m.

o House allowance 7,000 p.m.

o Car allowance 8,000 p.m.

He lived in the company house and paid rent of Kshs 5,000 p.m. to the employer and

received dividends of 20, 000 in December from BIDCO.

Required:

Calculate the taxable income.

Solution

Taxable income - Cash Benefits {12(30,000+7,000+8,000)} = 540,000

- Non-Cash Benefits {[15% of 540, 000]-[5, 000x12]} = (21,000)

= 561, 000

Notes:

- Dividends received from sources outside Kenya are not taxable.

- Distribution of profits of a company that is voluntary closing down is dividends

- Dividends received by a resident company are not considered to be income

(taxable) unless the company receiving such dividend controls less than 12.5% of

the shares of the paying company.

- Debentures and preference shears that are redeemable are dividends when issued

to the shareholders without any payment.

- Dividends paid by corporative societies are not qualifying dividends except

dividends paid by a savings and credit cooperative society

B. Interest Income
This is a payment received by a person from another person for money lent. Money

can be lent in the form of loan deposit in the bank or debt. Interest also includes any

premium or discount received by way of interest.

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a) Qualifying interest income

This is interest income received by individuals. It’s taxed at the point of payment

hence not taxable again.

NB: Qualifying interest income only relates to individuals

Qualifying interest for building society is restricted to Ksh.300, 000 p.a. any amount

above that is added back when getting total taxable income.

Illustration
Calculate the taxable income for Mr. Weunda for the year of income 2017 o

He owns shares in Unga Ltd. And has received dividend of 5, 000

o He earned interest of 3, 000

o He owns a house which he has let out from 1st April to 31stDecember at 5, 000 p.m. o

He paid 4,000 for his daughters’ school fees.

o His employment income was 15,000 p.m.

o He paid 10% of gross rent as rent collection fees

Solution

Income

o Salary (5,000x12) 180, 000

o Rent (5,000x9) 45, 000

o Rent collection fees (4, 500) (40,500)

Taxable Pay 220,500

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